Lecture Nine: Macroeconomics

Lecture Nine: Macroeconomics
From “Say’s Law” to … “Emergent Properties”

Macroeconomics is… Micro considers Behaviour of individuals & firms
Behaviour of markets Macro considers The behaviour of the whole economy And special “markets”: Labour Money And key variables Rate of employment, growth, inflation… In the beginning (before Keynes or Walras or even Smith), in Macro there was… Quite a lot of debate!

Mercantilists on Macro
Mercantilism in part justified tariffs, etc., on basis that it would increase employment: “5. The frugal expending likewise of our own natural wealth might advance much yearly to be exported unto strangers; and if in our rayment we will be prodigal, yet let this be done with our own materials and manufactures, … where the excess of the rich may be the employment of the poor, whose labours … would be more profitable for the Commonwealth, if they were done to the use of strangers.” (Thomas Mun, “England’s Treasure by Forraign Trade. or The Ballance of our Forraign Trade is The Rule of our Treasure”) i.e., an excess of exports over imports will increase employment…

Physiocrats (Quesnay)
The “Tableau Economique” First ever “input-output” model of whole economy First systematic attempt to think about relationship between productivity and output at level of whole economy Basic ideas: Objective of production to generate a “net surplus” over inputs Agriculture seen as only source of surplus Converts free energy of sun into plants, animals Manufacturing just transforms free gift; no added value Three classes: Farmers “the productive class” Manufacturing workers/firms “the sterile class” Feudal lords/clerics “the proprietor class

But manufactures needed to generate rural net product interdependence (multiplier, input-output concepts) Agriculture generates a surplus 1 unit of output requires < 1 unit of input Sow 1 kilo of wheat as seed, get 10 kilos of wheat as crop Manufacturing simply converts form 1 unit of input, 1 unit of output (but in different form) Surplus key to wealth: Wealth can be increased if gap between inputs and output in agriculture can be increased.

An example in modern terms: Old technology with 100 hectares of land: 1 hectare land + 7/10 bushels wheat + 1/10 kilo steel produces 1 bushel wheat 0 hectare land + 1/10 bushel wheat + 9/10 kilo steel produces 1 kilo steel 70 wheat + 10 steel -> 100 wheat 10 wheat + 90 steel -> 100 steel Net output 20 bushels wheat, 0 kilos steel

New technology with 100 hectares of land: 1/10th less bushels of wheat used: 1 hectare land + 6/10 bushels wheat + 1/10 kilo steel produces 1 bushel wheat 0 hectare land + 1/10 bushel wheat + 9/10 kilo steel produces 1 kilo steel 60 wheat + 10 steel -> 100 wheat 10 wheat + 90 steel -> 100 steel Net output 30 bushels wheat, 0 kilos steel Benefits of improved technology 16% reduction in inputs (from 7/10ths 6/10ths bushels) 50% increase in net product (from 20 to 30 bushels) Means more wealth for “proprietors”, more employment making for workers making “carriages”

From Physiocrats to Smith
Smith’s rejected Physiocratic idea that agriculture the only source of wealth: “Artificers and manufacturers, in particular, whose industry, in the common apprehension of men, increases so much the value of the rude produce of land, are in this system represented as a class of people altogether barren and unproductive” (Wealth of Nations Ch. 9) But input-output & surplus concepts lost as well… Smith much less concerned about macroeconomic issues The big “macroeconomic” debate amongst classical economists was Malthus vs Ricardo…

Ricardo vs Malthus Malthus asserted that
Aggregate demand could be less than supply A “general glut” Technological progress could lead to unemployment Ricardo confident that aggregate demand would always be sufficient: “Mr. Malthus asks “how is it possible to suppose that the increased [quantity of] commodities, obtained by the increased number of productive labourers should find purchasers, without [such] a fall of price as would probably sink their value below the cost of production, or, at least, very greatly diminish both the power and the will to save? “…

Ricardo vs Malthus “To which I [Ricardo] answer that
the power and the will to save will be very greatly diminished, for that must depend upon the share of the produce allotted to the farmer or manufacturer. But with respect to the other question where would the commodities find purchasers? If they were suited to the wants of those who would have the power to purchase them, they could not fail to find purchasers, and that without any fall of price.” Ricardo, Notes on Malthus' "Principles of Political Economy“ (pp ) Ricardo accepted there could be gluts of individual commodities, but not an overall excess of supply over demand:

Ricardo vs Malthus “Mistakes may be made, and commodities not suited to the demand may be produced—of these there may be a glut; they may not sell at their usual price; but then this is owing to the mistake, and not to the want of demand for productions. For every thing produced there must be a proprietor. Either it is the master, the landlord, or the labourer. Whoever is possessed of a commodity is necessarily a demander, either he wishes to consume the commodity himself, and then no purchaser is wanted; or he wishes to sell it, and purchase some other thing with the money…”

Ricardo vs Malthus Ricardo’s analysis based on “Say’s Law”: supply IS demand Only reason someone produces something is to sell it and buy something of equivalent value Hence supply is simultaneously demand (maybe with a little lag…) “Whoever has commodities has the power to consume, and as it suits mankind to divide their employments, individuals will produce one commodity with a view to purchase another;” Ricardo accepted arguments of Jean Baptiste Say here: “M. Say has, however, most satisfactorily shown, that there is no amount of capital which may not be employed in a country, because demand is only limited by production.” (Principles, Ch. 21)

“Say’s Law” Say’s Law best put by Say himself:
“Every producer asks for money in exchange for his products, only for the purpose of employing that money again immediately in the purchase of another product; for we do not consume money, and it is not sought after in ordinary cases to conceal it: thus, when a producer desires to exchange his product for money, he may be considered as already asking for the merchandise which he proposes to buy with this money. It is thus that the producers, though they have all of them the air of demanding money for their goods, do in reality demand merchandise for their merchandise.” (Say, Catechism of Political Economy)

“Say’s Law” Crises caused by “disproportionality” only
Excess supply in one market, excess demand in others “General gluts” or “general slumps” impossible Argument Money only an intermediary in barter People sell only to buy again (increase in utility the object) Each person’s supply is matched to his/her demand Sum of all supply thus cannot exceed sum of all demand (no “general gluts”); but

Basic logic “micro” in nature
“Say’s Law” Slumps in one market can occur if supply of X exceeds demand for X at price producers of X want; however Unless government regulations, monopolies intervene Price of X falls, demand for X rises: equilibrium… Basic logic “micro” in nature Hypothesis about behaviour of each individual in market system (micro) Aggregate hypothesis to overall economy (macro) Argument also essential “real” rather than monetary:

Ricardo & Say: the “Odd Couple”
Ricardo accepted Say on macro But differed on theory of value and price: “The value of a commodity … depends on the relative quantity of labour which is necessary for its production” (Ricardo) “Effort is the source of value” “No it ain’t! Utility is…” “What do you understand by the word Products ? … all those things to which men have consented to give a value. How is value given to a thing ? By giving it utility” (Say) “Say’s Law” dominated classical “macroeconomics” (even though neoclassical in origin) until…

Marx Debunks Say… Marx’s “circuits of capital”: C—M—C
“Of the part of the revenue in one branch of production (which produces consumable commodities) which is consumed in the revenue of another branch of production, it can be said that the demand is equal to its own supply (in so far as production is kept in the right proportion). It is the same as if each branch itself consumed that part of its revenue. Here there is only a formal metamorphosis of the commodity: C-M-C' Linen-money-wheat.” (Marx Theories of Surplus Value, 1861 p. 233) Supply implies demand; aggregate balance the rule…

Marx Debunks Say… But there is also M—C—M+
“The circuit C-M-C starts with one commodity, and finishes with another, which falls out of circulation and into consumption. Consumption, the satisfaction of wants, in one word, use-value, is the end and aim. The circuit M-C-M+, on the contrary, commences with money and ends with money. Its leading motive, and the goal that attracts it, is therefore mere exchange-value.” (Marx, Capital I 1867, p. 148) Demand in M—C—M+ can evaporate if expectations of profit collapse…

Marx Debunks Say… Aggregate demand is thus sum of two circuits C—M—C
Say’s Law applies M—C—M+ Say’s Law doesn’t apply Aggregate demand can therefore differ from aggregate supply Marx’s logical advance here lost in decline of classical school and rise of neoclassical Neoclassical school adopts Say’s Law as “Walras’s Law” “Sum of all excess demands is zero” No possibility of generalised slump… Dominates “macroeconomic” thinking before Great Depression

Pre-Keynesian Macro Conventional neoclassical macroeconomic theory less elaborate than Walras’s “General Equilibrium” model: Assumed fixed capital stock in short run, variable labor supply, etc., rather than “everything variable” as in Walras Example: Hicks’s “typical classical theory” (outlined in Hicks 1936, “Mr Keynes and the Classics”) 2 industries: Investment goods X; consumption goods Y 2 factors of production: labor (variable); capital (fixed in short run) Given capital stock in both industries:

Hicks’s “typical classical theory”
Output a function of employment Nx & Ny X=fx(Nx); Y=fy(Ny) where f has diminishing marginal productivity Prices equal marginal costs = marginal product of labour times wage rate (since labour is only variable input): Marginal cost is increase in labor input (dNx & dNy) for each increment to output (dx & dy) Px=w.dNx/dx; Py=w.dNy/dy Income = value of output = price times quantity: I = Ix + Iy = w.(dNx/dx) .x + w.(dNy/dy) .y

Quantity of Money M a given, and fixed relation between M and income I (transactions demand for money only: money “a veil over barter”): M = k.I (k constant “velocity of money”) Demand for investment goods a function of interest rate: Ix=C(i) Supply of savings a function of interest rate: Ix=S(i) Higher savings means higher investment (a familiar argument?) I (Interest rate) Ix (output of capital goods) Supply Demand Determines Nx

Causal chain: M determines I (total output) i determines Ix (output of investment goods) Ix determines Nx (given w) I-Ix determines Iy (output of consumption goods is a residual…) Iy determines Ny (given w) Lower money wage means higher employment: Lower wage means lower prices Unchanged money I means higher income relative to prices, so higher sales Higher sales mean increased employment (and lower real wage due to diminishing marginal product)

The Great Depression Neoclassical Macro
Asserted unemployment due to excessive wages, until... The Great Depression Arguably began with Stock Market Crash Just one week before…

The economists were saying…
“Stock prices have reached what looks like a permanently high plateau. I do not feel that there will soon, if ever, be a fifty or sixty point break below present levels, such as Mr. Babson has predicted. I expect to see the stock market a good deal higher than it is today within a few months.” (Irving Fisher, October ) In the next few years, Irving Fisher lost12 million dollars! That’s $102 million in 2000 prices Crash occurred on October 23rd 1929:

A 120 Point Break in just 15 Days...
Crash continued for another 3 years:

The Great Wall Street Crash
and that’s the index; the S&P of 1948 had many stocks which didn’t exist in 1929, while many of the 1929 entrants had gone bankrupt S&P 500 from 32 at its zenith 25 years to recover To below 5 at its nadir in less than 3 years Not only the Stockmarket crashed…

The Great Depression 10 years to restore output levels WW II
30% fall in output in 4 years

The Great Depression To 25% in 3 years WW II Brings Sustained Recovery
From effectively zero...

Keynes’s “Revolution”
A (partial) rejection of (neo)classical economics Kept marginal product theory of factor returns; but Rejected theory of investment, money, savings Key innovation: proper treatment of uncertainty Investment: in certain world, would be determined by interest rate in uncertain world, motivated by expectations of profit Expectations of profit volatile & based on flimsy foundations: Expect current state of affairs to continue; Trust current prices, etc., as correct Trust mass sentiment

Keynes’s “Revolution”: Investment & Savings
Investment (determined by expectations, output, capital stock) determines income via multiplier I=f(E,Y,K) (E component highly volatile) Y=f(I) Consumption a function of income C=a + c.Y (stable relationship) Y=C+I=C+S (ex-post Investment = ex-post Savings) Savings a residual function of income: S=Y-C Investment determines Savings Attempt to increase Savings (by reducing MPC) may reduce investment & hence output

Keynes’s “Revolution”: Money
Neoclassical theory: money a “veil over barter” transactions motive only for holding money Keynes Money ultimate source of liquidity in uncertain world Not only transactions, but also speculative, precautionary & finance motives for holding money (latter not in General Theory, but 1937 papers) Rate of interest the return for foregoing liquidity Liquidity preference highly volatile because based on expectations (as is Investment)

Keynes’s “Revolution”: Critique “Say’s Law”
Expenditure has 2 components: D1, related to current output (consumption) D2, not related to current output (investment) Say’s Law (rejected by Keynes) requires: either D2=0; or Increased savings causes increased D2 But Decision to invest based on expectations of profit in uncertain future Increased savings means decreased consumption now May lead to lower expectations and less investment Argument inspired by Marx’s C—M—C/M—C—M+, but Marx not cited—probably for political reasons:

Keynes’s “Revolution”: Critique “Say’s Law”
“One of the rare occasions in which Keynes praised Marx occurred in a 1933 draft of the General Theory. Here Keynes credits Marx with the “… pregnant observation … that the nature of production in the actual world is not C—M—C', i.e.. of exchanging commodity (or effort) for money in order to obtain another commodity (or effort). That may be the standpoint of the private consumer. But it is not the attitude of business, which is a case of M—C—M' , i.e.. of parting with money for commodity (or effort) in order to obtain more money” (1971, Vol. 29, p. 81, Keynes's emphasis). Dillard 1984 “Keynes and Marx: a centennial appraisal” Journal of Post Keynesian Economics p. 424 So Keynes’s published critique of Say’s Law not as clear as Marx’s:

In a nutshell... “The theory can be summed up by saying that, given the psychology of the public, the level of output and employment as a whole depends on the amount of investment... More comprehensively, aggregate output depends on the propensity to hoard, on the policy of the monetary authority as it affects the quantity of money, on the state of confidence concerning the prospective yield of capital-assets, on the propensity to spend and on the social factors which influence the level of the money-wage. But of these several factors it is those which determine the rate of investment which are most unreliable, since it is they which are influenced by our views of the future about which we know so little.” Keynes, 1937, “The General Theory…”, p. 221

Keynes and Investment under Uncertainty
1937 papers mark a shift from marginal concepts to “two price levels” In most of the General Theory, Keynes argued that investment was motivated by relationship between marginal efficiency of investment schedule (MEI) & interest rate In Chapter 17 of General Theory, “The General Theory of Employment” and “Alternative theories of the rate of interest” (1937), spoke in terms of two price levels investment motivated by the desire to produce “those assets of which the normal supply-price is less than the demand price” (Keynes 1936: 228) Demand price determined by prospective yields, depreciation and liquidity preference. Supply price determined by costs of production

Two price level analysis becomes more dominant subsequent to General Theory: The scale of production of capital assets “depends, of course, on the relation between their costs of production and the prices which they are expected to realise in the market.” (Keynes 1937a: 217) MEI analysis akin to view that uncertainty can be reduced “to the same calculable status as that of certainty itself” via a “Benthamite calculus”, whereas the kind of uncertainty that matters in investment is that about which “there is no scientific basis on which to form any calculable probability whatever. We simply do not know.” (Keynes 1937a: 213, 214)

What is “uncertainty”? Very hard to grasp, even though essential aspect of our world: we do not know the future But we have worked out how to calculate risk Most of Keynes’s examples were about how uncertainty is not risk Negative examples—what uncertainty is not—rather than what it is: “‘By "uncertain" knowledge, let me explain, I do not mean merely to distinguish what is known for certain from what is only probable. The game of roulette is not subject, in this sense, to uncertainty; nor is the prospect of a Victory bond being drawn….

Keynes on Uncertainty “Or, again, the expectation of life is only slightly uncertain. Even the weather is only moderately uncertain. The sense in which I am using the term is that in which the prospect of a European war is uncertain, or the price of copper and the rate of interest twenty years hence, or the obsolescence of a new invention, or the position of private wealth-owners in the social system in 1970. About these matters there is no scientific basis on which to form any calculable probability whatever. We simply do not know. Nevertheless, the necessity for action and for decision compels us as practical men to do our best to overlook this awkward fact and to behave exactly as we should if we had behind us a good Benthamite calculation of a series of prospective advantages and disadvantages, each multiplied by its appropriate probability, waiting to be summed.’”

What is “uncertainty”? Imagine you are very attracted to a particular person This person has accepted invitations from 1 in 5 of the people who have asked him/her out Does this mean you have a 20% chance of success? Of course not: Each experience of sexual attraction is unique What someone has done in the past with other people is no guide to what he/she will do with you in the future His/her response is not “risky”; it is uncertain. Ditto to individual investments success/failure of past instances give no guide to present “odds”

How to cope with relationship uncertainty?
We try to “find out beforehand” ask friends—eliminate the uncertainty We do nothing… paralysed into inaction We ask regardless… compel ourselves into action We follow conventions “follow the herd” of the social conventions of our society “play the game” & hope for the best So what about investors?

In the midst of incalculable uncertainty, investors form fragile expectations about the future These are crystallised in the prices they place upon capital asset These prices are therefore subject to sudden and violent change with equally sudden and violent consequences for the propensity to invest Seen in this light, the marginal efficiency of capital is simply the ratio of the yield from an asset to its current demand price, and therefore there is a different “marginal efficiency of capital” for every different level of asset prices (Keynes 1937a: 222)

Keynes on Uncertainty and Expectations
Three aspects to expectations formation under true uncertainty Presumption that “the present is a much more serviceable guide to the future than a candid examination of past experience would show it to have been hitherto” Belief that “the existing state of opinion as expressed in prices and the character of existing output is based on a correct summing up of future prospects” Reliance on mass sentiment: “we endeavour to fall back on the judgment of the rest of the world which is perhaps better informed.” (Keynes 1936: 214) Fragile basis for expectations formation thus affects prices of financial assets

Keynes on Finance Markets
Conventional theory says prices on finance markets reflect net present value capitalisation of expected yields of assets But, says Keynes, far from being dominated by rational calculation, valuations of finance markets reflect fundamental uncertainty and are driven by whim: “all sorts of considerations enter into the market valuation which are in no way relevant to the prospective yield” (1936: 152) ignorance day to day instability waves of optimism and pessimism “the third degree”

Ignorance due to dispersion of share ownership (shades of Telstra?): “As a result of the gradual increase in the proportion of equity ... owned by persons who ... have no special knowledge ... of the business... the element of real knowledge in the valuation of investments ... has seriously declined” (1936: 153) Anyone here got T2 shares?… Impact of day to day fluctuations “fluctuations in the profits of existing investments, which are obviously of an ephemeral and non-significant character, tend to have an altogether excessive, and even an absurd, influence on the market” (1936: )

Waves of optimism and pessimism “In abnormal times in particular, when the hypothesis of an indefinite continuance of the existing state of affairs is less plausible than usual ... the market will be subject to waves of optimistic and pessimistic sentiment, which are unreasoning and yet in a sense legitimate where no solid basis exists for a reasonable calculation.” (1936: 154) “The Third Degree” Professional investors further destabilise the market by attempting to anticipate its short term movements and react more quickly As Geoff Harcourt once remarked, Keynes “writes like an angel”. The next few slides are in Keynes’s own words. Skip Keynes Quotes…

“It might have been supposed that competition between expert professionals ... would correct the vagaries of the ignorant individual... However,... these persons are, in fact, largely concerned, not with making superior long-term forecasts of the probable yield of an investment over its whole life, but with foreseeing changes in the conventional basis of valuation a short time ahead of the general public... For it is not sensible to pay 25 for an investment of which you believe the prospective yield to justify a value of 30, if you also believe that the market will value it at 20 three months hence.” (1936: )

“Of the maxims of orthodox finance none, surely, is more anti-social than the fetish of liquidity, the doctrine that it is a positive virtue on the part of investment institutions to concentrate their resources upon the holding of ‘liquid’ securities. It forgets that there is no such thing as liquidity of investment for the community as a whole. The social object of skilled investment should be to defeat the dark forces of time and ignorance which envelop our future. The actual, private object of most skilled investment today is ‘to beat the gun’, as the Americans so well express it, to outwit the crowd, and to pass the bad, or depreciating, half-crown to the other fellow.” (1936: 155)

“professional investment may be likened to those newspaper competitions in which the competitors have to pick out the six prettiest faces from a hundred photographs, the prize being awarded to the competitor whose choice most nearly corresponds to the average preferences of the competitors as a whole; ... It is not a case of choosing those which, to the best of one's judgment, are really the prettiest, nor even those which average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practise the fourth, fifth and higher degrees.” (1936: 156)

“If the reader interjects that there must surely be large profits to be gained from the other players in the long run by a skilled individual who, unperturbed by the prevailing pastime, continues to purchase investment on the best genuine long-term expectations he can frame, he must be answered, first of all, that there are, indeed, such serious-minded individuals and that it makes a vast difference to an investment market whether or not they predominate in their influence over the game-players. But we must also add that there are several factors which jeopardise the predominance of such individuals in modern investment markets.”

“Investment based on genuine long-term expectation is so difficult today as to be scarcely practicable. He who attempts it must surely lead much more laborious days and run greater risks than he who tries to guess better than the crowd how the crowd will behave; and, given equal intelligence, he may make more disastrous mistakes. There is no clear evidence from experience that the investment policy which is socially advantageous coincides with that which is most profitable. It needs more intelligence to defeat the forces of time and ignorance than to beat the gun.”

“Moreover, life is not long enough;--human nature desires quick results, there is a peculiar zest in making money quickly, and remoter gains are discounted by the average man at a very high rate. The game of professional investment is tolerably boring and over-exacting to anyone who is entirely exempt from the gambling instinct; whilst he who has it must pay to this propensity the appropriate toll.” “Furthermore, an investor who proposes to ignore near-term market fluctuations needs greater resources for safety and must not operate on so large a scale, if at all, with borrowed money...”

“Finally it is the long-term investor ... who will in practice come in for most criticism, wherever investment funds are managed by committees or banks. For it is in the essence of his behaviour that he should be eccentric, unconventional and rash in the eyes of average opinion. If he is successful, that will only confirm the general belief in his rashness; and if in the short run he is unsuccessful, which is very likely, he will not receive much mercy. Worldly wisdom teaches us that it is better for reputation to fail conventionally than to succeed unconventionally.” (Keynes 1936: ) At the same time as Keynes was writing the General Theory, Irving Fisher put forward the very similar “Debt Deflation Theory of Great Depressions”:

Fisher on Depression Fisher’s reputation destroyed by prediction of no crash afterwards, developed theory to explain it “The Debt Deflation Theory of Great Depressions” Neoclassical theory assumed equilibrium but real world equilibrium short-lived since “New disturbances are, humanly speaking, sure to occur, so that, in actual fact, any variable is almost always above or below the ideal equilibrium” (1933: 339) As a result, any real world variable is likely to be over or under its equilibrium level—including confidence & speculation But two key problems are debt and prices

Debt Deflation Theory of Great Depressions
The “two dominant factors” which cause depressions are “over-indebtedness to start with and deflation following soon after” “Thus over-investment and over-speculation are often important; but they would have far less serious results were they not conducted with borrowed money. That is, over-indebtedness may lend importance to over-investment or to over-speculation. The same is true as to over-confidence. I fancy that over-confidence seldom does any great harm except when, as, and if, it beguiles its victims into debt.” (Fisher 1933: 341) When overconfidence leads to overindebtedness, a chain reaction ensues:

“(1) Debt liquidation leads to distress selling and to (2) Contraction of deposit currency, as bank loans are paid off, and to a slowing down of velocity of circulation. This contraction of deposits and of their velocity, precipitated by distress selling, causes (3) A fall in the level of prices, in other words, a swelling of the dollar. Assuming, as above stated, that this fall of prices is not interfered with by reflation or otherwise, there must be (4) A still greater fall in the net worths of business, precipitating bankruptcies and

(5) A like fall in profits, which in a "capitalistic," that is, a private-profit society, leads the concerns which are running at a loss to make (6) A reduction in output, in trade and in employment of labor. These losses, bankruptcies, and unemployment, lead to (7) Pessimism and loss of confidence, which in turn lead to (8) Hoarding and slowing down still more the velocity of circulation. The above eight changes cause (9) Complicated disturbances in the rates of interest, in particular, a fall in the nominal, or money, rates and a rise in the real, or commodity, rates of interest.” (1933: 342)

Fisher thus concurs with ancient charge against usury, that “it maketh many bankrotts” (Jones 1989: 55) Bankruptcy an individual problem in feudal system in capitalist economy, chain reaction can drag the economy into crisis… Theory nonequilibrium in nature “we may tentatively assume that, ordinarily and within wide limits, all, or almost all, economic variables tend, in a general way, towards a stable equilibrium” but though assumed stable, equilibrium is “so delicately poised that, after departure from it beyond certain limits, instability ensues” (Fisher 1933: 339).

Two classes of far from equilibrium events explained: Great Depressions, when overindebtedness coincides with deflation “the more debtors pay, the more they owe. The more the economic boat tips, the more it tends to tip. It is not tending to right itself, but is capsizing” (Fisher 1933: 344). Cycles, when one occurs without the other with only overindebtedness or deflation, economic growth eventually corrects situation; it “is then more analogous to stable equilibrium: the more the boat rocks the more it will tend to right itself. In that case, we have a truer example of a cycle” (Fisher 1933: )

Fisher’s new theory ignored Old theory made basis of modern finance theory Debt deflation theory revived in modern form by Minsky (a future lecture) Fisher’s macroeconomic contribution (which emphasised the need for reflation and “100% money” during the Depression) overshadowed by Keynes’s “General Theory” Many similarities and synergies in Keynes and Fisher, but different countries meant one largely unaware of others work Skip Keynes Quotes…

Keynes and Debt-deflation
Some consideration of debt-deflation in General Theory when discussing reduction in money wages (the neoclassical proposal for ending the Great Depression--see last lecture): “Since a special reduction of money-wages is always advantageous to an individual entrepreneur ... a general reduction ... may break through a vicious circle of unduly pessimistic estimates of the marginal efficiency of capital... On the other hand, the depressing influence on entrepreneurs of their greater burden of debt may partially offset any cheerful reactions from the reductions of wages. Indeed if the fall of wages and prices goes far, the embarrassment of those entrepreneurs who are heavily indebted may soon reach the point of insolvency--with severe adverse effects on investment.” (Keynes 1936: 264)

Keynes and Debt-deflation
“The method of increasing the quantity of money in terms of wage-units by decreasing the wage-unit increases proportionately the burden of debt; whereas the method of producing the same result by increasing the quantity of money whilst leaving the wage-unit unchanged has the opposite effect. Having regard to the excessive burden of many types of debt, it can only be an inexperienced person who would prefer the former.” (1936: ) Thus 2 reasons for favouring reflation/inflation as means to end Great Depression: accepted neoclassical argument that real wage had to fall for employment to rise (next slide) impact of rising price level on debt far safer than that of a falling price level.

Marginal Product of Labour
Keynes on Wages Since accepted marginal product theory, accepted that real wages had to fall for employment to rise: Increased output Output But argued cutting money wage would cut prices—no effect on real wage solution to depression was reflation, not deflation: increase output, real wages will fall Employment =real wage Marginal Product of Labour Nu Nf Reduces real wage

Keynes on Policy Reflate domestic economy to escape Depression:
Government deficit funding of public works Multiplier impact on output, employment Boost to investor expectations Maintain low interest rates International Balance of Payments system to avoid “beggar my neighbour” currency devaluations Central world monetary authority Fixed exchange rates, IMF approval for variation Trade deficit economies must deflate economies to reduce imports Trade surplus economies must reflate to boost imports

Keynesian Policy in Practice
Domestic policy recommendations became the norm Budget deficits to increase employment during slumps (but surpluses rarely achieved during booms for political reasons) Low interest rates International recommendations only half followed in “Bretton-Woods” agreement: Fixed exchange rates, IMF, etc. (US as standard) Pressure on deficit countries to deflate; but No pressure on trade surplus countries to reduce surplus (USA then major creditor—trade surplus—nation)

The interpretation of Keynes
General Theory highly influential, but read by few economists (let alone economic journalists!) Most relied upon summaries and textbook interpretations GT itself not precise; plenty of room for interpretation Key interpretation: Hicks 1936, “Mr Keynes & the Classics” IS-LM rendition of Keynes Hicks sets out “typical classical theory”: M=k.I (money supply & output), Ix=C(i) (investment demand), Ix=S(i) (savings supply) Argues that Keynes’s innovation is the proposition that the demand for money should obey marginal analysis:

A “marginal” interpretation of Keynes
“On grounds of pure value theory, it is evident that the direct sacrifice made by a person who holds a stock of money is a sacrifice of interest; and it is hard to believe that the marginal principle does not operate at all in this field” [Hicks, 1936] Proposes that M=L(i) (demand for money a decreasing function of interest rate) is “Liquidity Preference” this Keynes’s main innovation Multiplier [Ix = S(I)] comparatively “insignificant”

Keynes according to Hicks
“Mr Keynes begins with three equations, M=L(i), Ix=C(i), Ix=S(I) [in contrast to (neo)classical theory] “... the demand for money is conceived as depending upon the rate of interest (Liquidity Preference). On the other hand, any possible influence of the rate of interest on the amount saved out of a given income is neglected. Although it means that the third equation becomes the multiplier equation, which performs such queer tricks, nevertheless this second amendment is a mere simplification, and ultimately insignificant.” (M=L(i) is money demand; money supply M is assumed to be exogenous)

Keynes according to Hicks
In this model: Money demand/supply determines i Ms i i determines Ix Ix determines I via the multiplier Increase Ms->increase I Increase propensity to invest, or to consume-> increase I Md

Keynes “special theory”, according to Hicks
Ms i Money market determines int. rate Investment i interest rate determines Investment Md (liquidity preference) Ix=f(i) Ix M I (output) I (output) Output determines employment Investment determines Output Ix N (employment) I=f(Ix) The multiplier

Ms i Money market determines int. rate Investment i interest rate determines Investment Increasing Ms increases N: Md (liquidity preference) Ix=f(i) Ix M I (output) I (output) Output determines employment Investment determines Output Ix N (employment) Employment grows more than output because of diminishing marginal product I=f(Ix) The multiplier

Ms i Money market determines int. rate Investment i interest rate determines Investment Reducing LP increases N: Md (liquidity preference) Ix=f(i) Ix M I (output) I (output) Output determines employment Investment determines Output Ix N (employment) Employment grows more than output because of diminishing marginal product I=f(Ix) The multiplier

Keynes “general theory”, according to Hicks
“something appreciably more orthodox” [OREF 31] “The dependence of the demand for money on interest does not ... do more than qualify the old dependence on income. However much stress we lay upon the 'speculative motive', the 'transactions motive' must always come in as well.” Hicks’s version of Keynes’s “GT” M=L(I,i), Ix=C(i), Ix=S(I). vs Hicks’s version of “typical classical theory” M=k.I, Ix=C(i), Ix=S(i)

The LL (LM) curve: Fixed Ms; Md ¯ fn of i; Md fn of I: The LM curve Exogenous Ms i i Md1 (I2) Md1 (I1) I I2 I1 M

I (income) I (income) Ix=S(I) The IS curve: Investment demand a ¯ fn of i [Ix=C(i)]; Savings supply a fn of Income [Ix=S(I)] Savings a function of income S I (income) i Investment a function of interest rate i The IS curve Multiplier Ix=C(i) I(output) Ix (Investment)

The product: IS-LM analysis i LL (now LM) IS I (output)

Keynes as a marginalist [neoclassical], according to Hicks: “Income and the rate of interest are now determined together ... just as price and output are determined together in the modern theory of demand and supply. Indeed, Mr Keynes's innovation is closely parallel, in this respect, to the innovation of the marginalists.” Integrating “Keynes and the Classics”: Slope of LM curve almost horizontal for low levels of I almost vertical for high levels of I:

In “Keynesian” region, rightward shift of IS curve (by fiscal policy, etc.) mainly boosts income In “Classical region”, rightward shift of IS curve (by fiscal policy, etc.) mainly boosts interest rate “the General Theory of Employment is the Economics of Depression”, Classical is Economics of full employment i LM “Classical region” IS “Keynesian region” I (output)

Nice theory, but is it Keynes?
Whatever Happened to Uncertainty & Expectations? Hicks: Ix=f(i) Investment demand a function of the rate of interest (and income in more general model) Keynes: “Our knowledge of the factors which will govern the yield of an investment some years hence is usually very slight and often negligible” [OREF 4] “It would be foolish, in forming our expectations, to attach great weight to matters which are very uncertain... therefore, [we are] guided ... by the facts about which we feel somewhat confident, .... the facts of the existing situation enter … disproportionately, into the formation of our long-term expectations…” Why not Ix=f(i,I,E) where E is expectations?

Nice theory, but is it Keynes?
“Keynesian Economics” as practised Keynes minus uncertainty & expectations “Keynes without uncertainty is something like Hamlet without the Prince.” (Minsky, John Maynard Keynes, 1975, p. 57) Evolved towards the “Neoclassical synthesis” IS-LM macro grafted onto neoclassical micro Key architects Hicks & Samuelson Revival of neoclassical economics as Keynes criticised for having “bad microfoundations” “Protest” group of economists (Post-Keynesians) try to develop uncertainty-based interpretation of Keynes in opposition to dominant neoclassical synthesis view Curiously, one “protester” was John Hicks!

“IS-LM: An Explanation”
In 1979/80, Hicks commented that “The IS-LM diagram, which is widely, though not universally, accepted as a convenient synopsis of Keynesian theory, is a thing for which I cannot deny that I have some responsibility.” (Hicks 1979/80) saw two key problems with IS-LM as an interpretation of Keynes 2nd problem was time-period of model: Hicks’s used a week, Keynes used “a ‘short-period’, a term with connotations derived from Marshall; we shall not go far wrong if we think of it as a year” (Hicks 1980).

Not unreasonable to hold expectations constant for a week–and therefore ignore them. But keeping expectations constant over a year in an IS-LM model does not make sense, because “for the purpose of generating an LM curve, which is to represent liquidity preference, it will not do without amendment. For there is no sense in liquidity, unless expectations are uncertain.” (Hicks “Explanation”) I.e., why hold money for precautions/speculation, if expectations were constant? Can’t validly derive LM curve, because transactions are only reason for holding money when expectations constant

If expectations constant, then can’t be out of equilibrium if out of equilibrium, expectations must change!: “I accordingly conclude that the only way in which IS-LM analysis usefully survives–as anything more than a classroom gadget, to be superseded, later on, by something better–is in application to a particular kind of causal analysis, where the use of equilibrium methods, even a drastic use of equilibrium methods, is not inappropriate…” “When one turns to questions of policy, looking towards the future instead of the past, the use of equilibrium methods is still more suspect. For one cannot prescribe policy without considering at least the possibility that policy may be changed. There can be no change of policy if everything is to go on as expected–if the economy is to remain in what (however approximately) may be regarded as its existing equilibrium.” (Hicks “Explanation”)

Keynesian Theory in Practice
Despite Hick’s disavowal of his own model, the interpretation of Keynes was dominated by IS-LM, and Aggregate Demand-Aggregate Supply (AS-AD) analysis Emphasis upon fiscal policy No attention to issue of expectations Policy focus post-Depression, WWII: Full employment primary Australian 1945 White Paper on Employment: "maintain such a pressure of demand on resources that for the economy as a whole there will be a tendency towards a shortage of men instead of a shortage of jobs" Price stability secondary

Keynesian Theory in Practice
“Although we have defined the boundary of the full-employment zone in terms of registered unemployment of 1.0 to 1.5 per cent of the work force, this is by no means to say that Australia should be content with this degree of unemployment. It should be possible to maintain employment at a higher level than this and avoid the difficulties arising from shortages and bottlenecks…” Vernon Committee, 1966 The scorecard: Recovery from Great Depression Years of high stable growth, low inflation Ending with rising inflation during Vietnam War Years, and severe collapse in 1973 (before OPEC!)

Breakdown of Keynesianism: “Philips Curve”
1958 study identifies relationship between unemployment & rate of change of money wages Consonant with Keynes on real wages and employment Inc. output —> decrease real wages —> prices must rise “Inflation-unemployment trade-off” perceived as core of Keynesian policy 1960s--accelerating inflation. “Breakdown” of Philips’ Curve opens door to Friedman’s monetarism

The Phillips Curve 3 factors which might influence rate of change of money wages: Level of unemployment (highly nonlinear relationship) Rate of change of unemployment Rate of change of retail prices “operating through cost of living adjustments in wage rates… when retail prices are forced up by a very rapid rise in import prices … or … agricultural products.” [Economica 1958 p ] Cost-based perspective on prices Developed curve from UK wage change/unemployment statistics from Only 1st of 3 causal factors shown in curve

The Phillips Curve Found a “clear tendency” for
inverse relation between U and rate of change of money wages (Dwm) Dwm above curve when U falling, and v.v Fitted exponential curve to data: Unemployment Dwm

The Phillips Curve Deviations from trend because of:
Fitted through average wage change & U for 0-2,2-3,3-4, 4-5,5-7,7-11% unemployment Wage-price spiral due to wars; falling U Rising unemployment

The Phillips Curve fitted to 1913-1948 data
Rapid rise in U; 13% fall in M prices; “cost of living” agreements War-induced rise in M prices

The Phillips Curve: 49-57 data with time lag
Close fit of 50s UK data to curve Import price rise

The Phillips Curve Conclusion: Phillips extrapolates from money wages to price inflation: “Ignoring years in which import prices … initiate a wage-price spiral, which seems to occur very rarely except as a result of war, and assuming an increase in productivity of 2% p.a., … [for] a stable level of product prices … unemployment would be … 2.5%. [For] stable wage rates … about 5.5%” [p. 299] An inflation-unemployment trade-off? But Phillips’ main purpose for developing it was to provide an input for his dynamic models in which unemployment, output, etc., varied cyclically.

The Phillips Model… “RECOMMENDATIONS for stabilising aggregate production and employment have usually been derived from the analysis of multiplier models, using the method of comparative statics. This type of analysis does not provide a very firm basis for policy recommendations, for two reasons. First, the time path of income, production and employment during the process of adjustment is not revealed. It is quite possible that certain types of policy may give rise to undesired fluctuations, or even cause a previously stable system to become unstable, although the final equilibrium position as shown by a static analysis appears to be quite satisfactory. Second, the effects of variations in prices and interest rates cannot be dealt with adequately with the simple multiplier models which usually form the basis of the analysis.” (Phillips 1954: 290) Phillips built a dynamic model:

The Phillips Model… Shown using flowchart: showed one variable (e.g., unemployment) affecting rate of change of another (e.g., money wages…) As part of model, postulated nonlinear relationship between output and wage/capital price inflation: Level of D Rate of change of P

The Phillips Model… “We may therefore postulate a relationship between the level of production and the rate of change of factor prices, which is probably of the form shown in Fig. 11…” (308) Did research on Phillips curve to justify this part of his dynamic model Instead, “trade-off” static interpretation becomes part of orthodox Keynesianism… Unfortunately, static relation didn’t seem to hold…

The Phillips Curve: Breakdown…?
OPEC I Vietnam war OPEC II

The rise of monetarism Friedman’s explanation: adaptive expectations, the short run trade-off but long run vertical Phillips curve Basic model: Exogenously given money-supply (“helicopters”) Walrasian economy in long-run equilibrium: all prices currently market-clearing No sale of capital assets possible Static-stochastic economy: no growth, aggregates constant, but random disturbances to individuals “Aggregates are constant, but individuals are subject to uncertainty and change. Even the aggregates may change in a stochastic way, provided the mean values do not.” (Friedman, Optimal Quantity of Money)

Back to Hicks’s pre-Keynesian “typical classical theory”
Monetarism Basic model (cont.) Motives for holding money: Transactions (barter motive) “uncertainty” says Milton, but: means of aggregates constant, stochastic variation only? Risk, not uncertainty. No variation in parameters of risk considered Holdings of money related to level of transactions: Md = k.I Exogenous increase in Ms—> initial increase in output but constrained by already fully-employed economy price level bid up till “real value” of money holdings restored Back to Hicks’s pre-Keynesian “typical classical theory”

Monetarism Continuous growth in Ms?
(corresponds to policy for lower U under Phillips curve inflation/U tradeoff) “which, perhaps after a lag, becomes fully anticipated by everyone”; adaptive expectations [OREF II] results in… Adaptive Expectations (with certainty) “what raises the price level, if at all points markets are cleared and real magnitudes are stable? ... Because everyone confidently anticipates that prices will rise…” Increasing Ms raises prices, no impact on output in long run (short run impact until expectations adapt)

Adaptive Expectations and the Phillips Curve
“Long run Phillips Curve” Target Rate Accelerating inflation needed to sustain target Short run gain with long run pain... Inflation SRPC3 DMs causes some growth but… SRPC2 Expectations adapt Expected Inflation= DMs- DLab.Prod SRPC1 Expectations adapt Economy returns to pre-existing “natural” rate Unemployment Initial “natural” U rate with zero expected inflation

From Monetarism to Rational Expectations
Friedman adaptive expectations expectations adapt to change after experience of inflation caused by increased money supply short-term impact of policy neutralised in long term Rational Expectations (Muth/Sargent): expectations predict consequence of change based on rational model of reality: “expectations … are essentially the same as the predictions of the relevant economic theory.” [OREF III] Combined with lag formulae as explanation for cycles: See chaos theory, later Expected price in cyclical market a weighted sum of previous prices

Rational Expectations Macro
“the public knows the monetary authority’s feedback rule and takes this into account in forming its expectations… unanticipated movements in the money supply cause movements in y [output], but anticipated movements do not.” “Predictions of relevant theory” are: increased Ms will increase price level —> instant adjustment of prices to government Ms policy —> no impact on output “Natural rate” of unemployment + rational expectations = policy ineffectiveness hypothesis:

Rational Expectations Macro
“by virtue of the assumption that expectations are rational, there is no feedback rule that the authority can employ and expect to be able systematically to fool the public. This means that the authority cannot expect to exploit the Phillips curve even for one period.” A vertical Phillips curve in short run Prediction that policy could never have been effective Short-run movements in unemployment due to unanticipated shocks

Problems for Rational Expectations
(1) Was Keynesian policy “ineffective”? By RE, differences between Keynesian & Neoclassical policy periods should be Higher M growth, Inflation No difference in unemployment (2) Why the Great Depression? “Natural rate” moves by 30%??? (3) Movement of “natural rate” (hysteresis?) (4) Nature of expectations Keynes: behaviour under fundamental uncertainty RE: behaviour under certainty, and using economic theory to predict it accurately…

From Macro to Applied Micro
Movement from Keynes to Rational Expectations stage in attempt by microeconomists to make macro a branch of micro At advanced level, micro studies inter-related behaviour of all markets in an economy Known as “general equilibrium” To some micro theorists, the “general” in “general equilibrium” makes it the same as “macroeconomics” But micro based on Marshall & Walras Macro originally based on Keynes Since development of General Equilibrium analysis, micro theorists have been trying to “make micro and macro consistent” Ultimate outcome: “Representative Agent Macroeconomics”…

Representative Agent Macroeconomics
Treats entire economy as single “Representative Agent” Agent owns sole firm in economy Works as sole employee for the firm Earns all profits from firm Decides how much to work on labour/leisure tradeoff Firm always in equilibrium with marginal cost = Price Random shocks explain trade-cycle Here “macro is micro” But problems “Representative agent” not justified by micro theory Covered in Critiques lecture, but in a nutshell:

Macro and “Emergent Properties”
At macro level, interactions between agents mean markets do not behave like “large” individuals Even if neoclassical micro accurately describes firms & consumers at the individual level Market demand curves can be “wrong” Equilibrium of Supply & Demand may Not exist; Or be unstable; Or have multiple intersections Macro phenomena of unemployment, inflation, may be “emergent phenomena” Can’t reduce macro to applied micro Explained in more detail in Critiques lecture…

Lecture Nine: Macroeconomics

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Lecture Nine: Macroeconomics

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